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Monday, October 24, 2005

Looking East

BP made news recently with a set of announcements concerning some big investments in India and China. They will apparently invest several billion dollars building a new refinery in India and refining and marketing assets in China, both in conjunction with large local partners. While this seems to answer those who have criticized the major oil companies for reinvesting too little in the business and returning too much of their profits to shareholders, the profit mechanisms for these new ventures are by no means certain, if past experience in the region is any indication.

Most of the large oil companies began to look for opportunities in China and India in the early 1990s, after a decade of highly profitable growth in the smaller, but rapidly growing countries of Asia, including Thailand, Malaysia, Singapore, and the Philippines. Exxon and Shell were early leaders in this race, forging substantial relationships with large state companies such as Sinopec and the Indian Oil Company (IOC). Turning these beachheads into thriving businesses has proved harder, however, and a decade has passed with only gradual evolution in the areas most critical for the creation of profitable, free-market based businesses. A handful of local companies still enjoy quasi-monopolies, and governance and partner relations still cause serious concern among investors.

Clearly, both of these countries will need significant foreign investment to develop their petroleum sectors to support both economic growth and increasing mobility. But it would be a mistake to assume that means they will develop along Western lines, or in ways that will contribute meaningfully to the bottom line of those companies investing there. This is particularly true in China, where the oil sector is still viewed as a "pillar industry."

In effect, the majors are in a quandary. They must reinvest the tremendous cash flows they are throwing off currently, or else risk being marginalized in the decade ahead by the state oil companies that control most of the world's oil and gas reserves. As many analysts have observed, the best upstream oil opportunities are off-limits, locked up either by resource nationalism or environmental restrictions. The majors also need to show the markets that they can extend their record of profitable growth, in order to keep share prices advancing and thus total return to shareholders high, and where better to do this than the most populous, fastest growing countries on earth?

But having operated in this area for so long, they can't be under any illusions about the risks they are taking on, and that one of the likeliest outcomes is a wave of new refinery construction that will alleviate current global tightness in refining capacity, destroying refining margins in the process and undermining the profitability of the entire global downstream sector. That might sound good from a consumer perspective, but it could leave the big oil companies strapped for cash at just the point they'd need to be spending big money bringing alternative energy projects on line, if conventional oil supplies can't keep up with demand.